More on the credit crunch and ETFs

By John Spence

Lehman Brothers filing for bankruptcy has the ETN world abuzz. Exchange-traded notes are similar to ETFs, but they carry credit risk. That difference has thrust ETNs into the spotlight during the market storm.

I spoke to Morningstar’s ETF expert, Scott Burns, today. He also penned a recent story on the credit risks of ETNs.

Lehman issued three ETNs which were included in the company’s defaulting on its debt. That means any holders would have to stand in line with other unsecured creditors.

The good news, Burns says, is that there was very little trading in the ETNs “at the very end,” and he thinks most of the remaining $15 million in the trio was seed money.

However, investors should note that Morgan Stanley sponsors four currency ETNs. Morgan Stanley along with rival investment bank Goldman Sachs recently moved to become bank holding companies. Since ETNs essentially represent a promise by an institution to pay an index return, it is only as strong as the issuer. “Morgan Stanley appears fine now, but we’ve heard that before,” Burns said. Other ETN issuers include UBS, Barclays and Deutsche Bank.

The Morningstar analyst noted that with $6 billion in assets, the ETN business still represents only about 10% of the more than $600 billion held in exchange-traded funds, or ETFs.

Investors in ETFs can breathe somewhat easier because shares represent a stake in an investment portfolio. If an ETF sponsor like State Street or Barclays went down, at worst the investors would receive cash or the shares, Burns said.

Still, ETFs haven’t sidestepped the credit turmoil. For example, the largest ETF by assets, the S&P 500-tracking SPDR Trust (SPY), lost more than 7% during Monday’s plunge. That was the ETF’s biggest daily pullback ever — it was listed in 1993.

One fund caught in the crosshairs is Market Vectors Russia ETF (RSX), which is managed by Van Eck Global. In fact, Burns on Monday wrote that international and emerging markets stocks took most of the damage during the sell-off.

Russia’s two main stock exchanges temporarily halted trading Tuesday morning to halt a slide. European central banks were pumping liquidity into the system to stave off a banking panic. Through Friday’s close, the Market Vectors had lost more than half its value over the trailing three months.

Recent market events have also led to other rumblings in ETF-land.

For example, Morningstar recently wrote about the potential challenges for leveraged, inverse and commodities ETFs. The funds use index swaps and derivatives, and there could be trouble if counterparties default.

Finally, Burns on Tuesday said there have been reports of premiums and discounts popping up in bond ETFs during the credit crunch. This is an issue because ETFs have an arbitrage mechanism designed to keep the price of an ETF share inline with the net asset value, or NAV. We’ll see if we can dig up more here.

Sorry for the recent lull in postings — I missed all the market fun last week due to a prescheduled vacation.